MONDAY MORNING RISK MONITOR: THE RELENTLESS RISE OF THE TED SPREAD

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More than any other measure in our Risk Monitor, we advise keeping an eye on the trend in the TED spread, which continues to climb. As a gauge of interbank lending anxiety it has been sending one message consistently for months now: risk in the banking system continues to rise. This nervousness is mirrored in the downward longer-term trend in bank equities. Until we see a meaningful leveling off and then reversal in the TED spread investors should not assume the systemic risks have been properly addressed.

1. US Financials CDS Monitor – Swaps widened for 24 of 27 major domestic financial company reference entities last week.

Widened the most vs last week: GS, MS, RDN

Tightened the most vs last week: MTG, MBI, AGO

Widened the most vs last month: MS, MTG, RDN

Tightened the most vs last month: LNC, MBI, GNW

2. European Financials CDS Monitor – Bank swaps were wider in Europe last week for 32 of the 40 reference entities. The average widening was 6.2% and the median widening was 11.5%. The German bank Bayerische Hypo- und Vereinsbank saw swaps widen by almost 30%. In addition, the four Italian banks we track saw swaps widen an average of 18%.

3. European Sovereign CDS – European sovereign swaps mostly widened last week. Spanish sovereign swaps widened by 7% (+28 bps to 427) and French by 11% (+20 bps to 202).

9. Markit MCDX Index Monitor – The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 14-V1. Last week spreads widened, ending the week at 172 bps versus 163 bps the prior week.

NYSE Margin debt hit its post-2007 peak in April of this year at $320.7 billion. The chart below shows the S&P 500 overlaid against NYSE margin debt going back to 1997. In this chart both the S&P 500 and margin debt have been inflation adjusted (back to 1990 dollar levels), and we’re showing margin debt levels in standard deviations relative to the mean covering the period 1. While this may sound complicated, the message is really quite simple. First, when margin debt gets to 1.5 standard deviations or greater, as it did this past April, that has historically been a signal of extreme risk in the equity market - the last two times it did this the equity market lost half its value in the ensuing period. We flagged this for the first time back in May of this year. The second point is that margin debt trends tend to exhibit high degrees of autocorrelation. In other words, the last few months’ change in margin debt is the best predictor of the change we’ll see in the next few months. This is important because it means that margin debt, which has retraced back to +0.43 standard deviations as of September, still has a long way to go. We would need to see it approach -0.5 to -1.0 standard deviations before the trend reversed. There’s plenty of room for short/intermediate term reversals within this broader secular move, but overall this setup represents a material headwind for the market.

One limitation of this series is that it is reported on a lag. The chart shows data through September.

Joshua Steiner, CFA

Allison Kaptur

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